Abenomics’ Growth Challenge

Slowing growth in the world’s third-largest economy has challenged the growth story mapped out by Japanese Prime Minister Shinzo Abe. Analysts have not written off his “Abenomics” policies just yet, however.

On Thursday, Japan’s Cabinet Office announced that growth in real gross domestic product (GDP) slowed to an annualized rate of 1.9 percent in the July-September quarter, down from the rapid clip of nearly 4 percent in the previous two quarters.

Weaker exports to emerging markets, the current destination for two-thirds of Japanese exports, cut 1.8 percentage points from GDP. Consumer spending, which accounts for around 60 percent of the economy, rose by only 0.1 percent over the summer.

Corporate investment also disappointed, rising by just 0.7 percent compared to the previous quarter’s 4.4 percent, as a weaker yen failed to fire increased production.

“Warning lights are flashing for Abenomics,” Kiichi Murashima, chief economist at Citigroup Inc. in Tokyo, told Bloomberg News. “With the absence of further weakening in the yen and a clear global recovery, Japan’s recovery is losing momentum.”

However, the GDP data exceeded market expectations of a 1.7 percent annualized gain, with Tokyo stocks finishing more than 2 percent higher on the news. On a seasonally adjusted basis, real GDP reached $5.3 trillion, its highest level since 2001.

The benchmark Nikkei Stock Average has risen by more than 70 percent over the past year, helped by a weaker yen that has boosted the profits of exporters such as Toyota Motor and boosted confidence in Abenomics.

According to the Nikkei, economists’ forecasts for fiscal 2014 growth are still averaging close to 1 percent, despite the looming consumption tax increase set for April, and above the Cabinet Office’s estimate for potential growth of 0.7 percent.

The business daily also pointed to higher prices and pay as offering reason for optimism that an end to deflation is near. The domestic demand deflator posted its first increase in five years in the latest quarter, rising 0.5 percent on the year, while the broader GDP deflator’s decline eased for the second straight quarter.

Nominal employee compensation gained 0.5 percent on the year, rising for a second consecutive quarter as labor market conditions tighten, with companies reportedly set to hand out bigger winter bonuses and wage hikes.

Economists polled by the Nikkei expect real GDP to recover in the current quarter to an annualized 3.3 percent pace, increasing to 4.3 percent for the January-March period before the consumption tax hike takes effect.

According to an October 29 report by FocusEconomics, Japanese GDP is expected to expand by 1.9 percent in 2013 and 1.7 percent next year, with inflation reaching the Bank of Japan’s target of 2 percent in 2014.

Having fired two arrows of fiscal and monetary stimulus, Abe has promised to deliver the “third arrow” of structural reform in the current parliamentary session ending December 6, including deregulatory economic zones and incentives to boost private investment, among other measures.

Reflation Key to Success

Japan analyst Naomi Fink, chief executive of Europacifica Consulting, told The Diplomat that reflation was critical for the success of Abenomics.

“Reflation is the basis wherein any future reforms, fiscal and structural, might take place, and the balance is a delicate one. The best possible scenario for Japan is one in which the U.S. experiences a gradual, reflationary recovery, boosting asset prices and Japanese stocks, which in turn will add credibility to Abe’s economic policy platform. Reflation then makes the consumption tax hike more palatable, which is the pathway to structural reform as well,” she said.

“There is no guarantee that this happens, but note that the ESP poll of 40 Japanese forecasters is relatively positive on this front. They foresee one quarter’s drop in third-quarter GDP, followed by a renewed surge ahead of the consumption tax hike next year, and only a temporary negative effect on domestic demand from the consumption tax.

“One dependency of course is that almost all assume that an extra budget will help ease the introduction of the tax hike, though even without an extra budget, all see mildly positive growth. Also, forecasters see steady positive contributions from external demand, so an unforeseen slowdown in the U.S. or China could disrupt this delicate balance. These external risks, in my mind, are the greater risks to growth as well as the future of Abenomics.”

Improved government finances from higher tax receipts could boost the prospects of free trade reforms, such as the Trans-Pacific Partnership, by allowing greater government subsidies to farmers, as well as “more comprehensive unemployment insurance in the event of eventual labor reform,” the economist said.

Without reflation, “the government will experience an ever-narrower margin to offer stimulus in times of recession,” she warned.

Will Abe’s high-risk gamble on growth pay off? For now, economists still give Abenomics a reasonable chance of success.